Delta’s Oil Refinery Plan Flies Against Economic Sense

April 20 (Bloomberg) -- When I saw that Delta Air Lines
Inc. is negotiating to buy an idled Pennsylvania oil refinery in
hopes of saving money on its fuel bill, I had a flashback to
July 7, 1981.

Back then, I was an intern in the now-defunct Philadelphia
bureau of the Wall Street Journal, and DuPont Co. had just
announced its agreement to buy Conoco Inc. for about $7 billion
in cash and stock. At the time, it was the largest corporate
merger in history.

Our little bureau mobilized to cover the story and, as the
least knowledgeable of the crew, I was given the simplest job:
Call a bunch of Wall Street analysts and ask them what they
thought. It was an especially easy assignment, because they all
said the same thing. Buying an oil company was a clever idea,
they told me. It would give DuPont a reliable supply of oil for
its petrochemicals and protect the company from price increases.

The market disagreed -- DuPont’s stock price went down on
the news -- and the conventional wisdom soon changed. (DuPont
finally spun off its Conoco division in 1999.) But in those
early hours, everybody I talked to thought the merger was a
smart move. And, because I was a naive intern, I believed them.

Vertical integration fools a lot of people.

Trust the Market

Back in 1981 I didn’t ask the right questions: For
starters, why couldn’t DuPont just contract to buy oil from
Conoco? Why own the company?

“If markets work well, you’re always better off using the
market. Let somebody specialize in what they do and trade with
them,” says Richard N. Langlois, an economist at the University
of Connecticut whose work on what he calls the “vanishing
hand” looks at why corporations have become less vertically
integrated in recent decades. “If there are markets that are
well functioning for your inputs and there aren’t high
transaction costs or other problems, you’re generally better off
buying things in markets than owning them yourself.”

The vertical integration that Alfred Chandler chronicled in
his influential 1977 book “The Visible Hand,” Langlois argues,
was “an adaptation to particular historical circumstances” --
specifically, underdeveloped input markets. To run a meatpacking
business in the 19th century, Gustavus Swift had to own an ice
company, a railroad-car maker and a lot of refrigerated
warehouses. Nowadays, most businesses can rely on well-developed
networks of independent suppliers and concentrate on whatever
they’re especially good at.

In Delta’s case, that means flying airplanes, not refining
oil. Delta doesn’t need its own refinery to obtain jet fuel,
which is traded in a thick worldwide market, any more than it
needs to own a peanut farm to supply in-air snacks. And it seems
unlikely that Delta would be noticeably better at running a
refinery than any other potential buyer -- or, for that matter,
ConocoPhillips, which plans to close down the refinery if it
can’t make a deal.

The proposed purchase “doesn’t make a huge amount of
economic sense -- in fact quite the opposite,” says Craig
Pirrong, a finance professor and director of the Global Energy
Management Institute at the University of Houston’s Bauer
College of Business.

You might think that owning a refinery would at least
protect the airline from price fluctuations. But, Pirrong notes,
crude oil prices affect the profits of airlines and oil
refineries exactly the same way. When oil prices go up, their
profits go down. Owning a refinery would simply magnify the
effect. “If anything,” he says, “it increases the risk
exposure that has bedeviled the airline industry for years.”

Increasing Your Risk

Delta simply seems to be falling for the great fallacy of
vertical integration: the belief that the inputs you get from an
in-house supplier are cheaper than those you buy in the open
market. There’s no markup. You’ve cut out the middle man!

But this story misses the real cost of those inputs.

Consider a thought experiment. Suppose Delta owns the
refinery and the market price of jet fuel goes so high that
buying fuel on the open market would make many of Delta’s
flights unprofitable. Should Delta managers sigh with relief and
fly those otherwise unprofitable flights, using fuel from their
own refinery? Or should they take that fuel, sell it at those
high market prices, and cancel the unprofitable flights?

The real cost of the fuel is not whatever expenses the
company incurs to produce it. The real cost is what the company
is giving up to use the fuel itself: the price it would command
in the market (markup included). If managers sacrifice refinery
profits to fuel their flights, those costs are just as real as
out-of-pocket expenditures.

If you picked “sigh with relief,” let’s hope you’re an
intern.

(Virginia Postrel is a Bloomberg View columnist. She is the
author of “The Future and Its Enemies” and “The Substance of
Style,” and is writing a book on glamour. The opinions
expressed are her own.)